July 12, 2018 - Loan returns were once again barely positive in June.  Following May’s 0.17% return, the S&P/LSTA Leveraged Loan Index returned just 0.12% in June – a seven-month low.  In total, second quarter returns hit a 10-quarter low of 0.7%. Happily, first half returns still came in at a respectable 2.16% — and that 2.16% is not too shabby given that high yield bond returns are just 6 basis points through the first six months of the year, while high-grade and 10-year treasuries are firmly in the red at -3.13% and -2.69%, respectively.  That said, market value (MV) returns in the loan market were negative for the fifth month running. (While this was the worst showing in 11 months, MV returns have been positive just once since last November).

And as reported in May, market breadth once again was decisively negative as MV losses remained widespread across the secondary.   Case in point, 71% of loans reported MV losses in June, while just 17% of loans reported gains.  In other words, for every one loan price that advanced in June, 4.2 declined; this is worse than May’s decliner ratio, which came in at 3.7:1.  Hit hardest was the cohort of loans trading above par, which experienced a 26 percentage point drop in market share in June (54% to 28%); this was more than double the decline experienced in May (66% to 54%).  All told, the market’s average bid level fell 30 basis points in June after dropping 23 basis points in May.  By the end of the second quarter, the market’s average bid level of 98.05 was flat on the year.

So, why did the secondary trade down over the past two months?  At first blush, investors might suggest geopolitical unrest and the trade war.  But that was not the case given that riskier assets (equities and HY bonds) enjoyed their best two-month run of 2018.   Instead, a shift in loan market technicals, which produced a worthwhile relative value trade between the primary and secondary markets, seemed to be a likely reason.   But it wasn’t like demand diminished during the past two months; it was quite the opposite.  On the visible demand side, CLO issuance averaged $12.7 billion over the past two months (above its 12-month average of $11.1 billion) while loan mutual fund inflows totaled $5.7 billion (the best two-month period in years).   In total, visible demand came in north of $31 billion since April.  But, the size of the market (the LLI) grew by a staggering $42 billion over the same period, which led to an $11 billion supply surplus.  And while prices did in fact weaken in the secondary, there was a silver lining to the second quarter story.  The primary market showed signs of becoming more investor friendly for the first time this year. As an example, the ratio of issuer-friendly price flexes to investor-friendly price ones fell to just 1.1x during the second quarter, from 6.8x in the first quarter, wrote LCD.  And a result, new issue B/B+ spreads rocketed to L+379 by the end of June, up 43 basis points since March.

For more information, please contact Ted Basta.

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